Exchange-traded interest rate options

In this section we will explore exchange-traded interest rate options— contracts traded on organised exchanges. In contrast, OTC options offered by banks will be examined in the next section. 

Statistics on the relative size of the European market for exchange-traded interest rate options are relatively easy to come by, and the Bank for International Settlement (BIS) publishes a regular breakdown of geographic activity. This is summarised in Exhibit 17.15, which shows how notional amounts outstanding on European exchanges have quadrupled over the 3-year period from 1999 to 2002. 

EXHIBIT 17.15 Geographic Breakdown of Exchange-Traded Interest Rate Options... 

In a later section we will examine why investors and others might want to use these exchange-traded bond options. Before this, however, we will turn our attention towards the other major exchange-traded interest rate product, short-term interest rate options. 

This chapter explores interest rate options—a vitat part of the European fixed income securities market. The first section tooks at exchange-traded options, where 20 bittion worth of bond options and over 250 billion of options on short-term rates change hands every day. Next, we ll look at the flexible OTC markets for interest rate options, including caps, collars, swaptions, and structured products. Finally, having explained the products themselves, we ll move on to explore how they can be used to hedge interest rate risk. 

Until recently, the interest rate options market was dominated by OTC transactions—trades executed directly between professional counterparties like banks, insurers, investment institutions, and corporates. However, as Exhibit 17.14 shows, dramatic growth of the exchange-traded markets in recent years has seen them catch up with the OTC markets in terms of notional amounts outstanding, and the two are now neck-and-neck. 

Despite the recent growth of exchange-traded products, the OTC market is still very much a major feature of the interest rate options... 

Unfortunately, without a central clearing house to monitor and record all transactions, it is difficult to obtain reliable statistics for the OTC interest rate options market. However, the BIS conducts regular surveys of the markets and publishes a breakdown of notional amounts outstanding by currency (but not by country) of all interest rate derivatives (including swaps, ERAs, futures, as well as options) across all markets (OTC as well as exchange-traded). A summary of this is shown in Exhibit 17.16, from which it can be seen that the size of the euro-denominated market now virtually matches that of the US dollar, signalling the increasing importance of the European interest rate derivatives market. 

Euronext-LIFFE s 3-month EURIBOR futures option, traded on the Chicago Mercantile Exchange, is an actively traded short-term interest rate option that enjoys high trading volume. If these options are exercised, the buyer and the seller of the option take positions in an underlying 3-month EURIBOR futures contract. The futures contract is cash-settled and the final price at delivery is equal to 100 minus the 3-month LIBOR. 

American Stock Exchange (AMEX) The second-largest stock exchange in the United States, after the NYSE. Stocks and bonds traded on the AMEX tend to be those of smaller companies than on the NYSE. Some index options and interest rate options trading also occurs on the AMEX. Also called The Curb. 

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